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The Removal of Credit Ratings from Capital Regulation: Implications for Systemic Risk

We examine whether removing references to credit ratings from regulations, as mandated by the Dodd-Frank Act, affects the transmission of systemic risk through the asset liquidation channel. We analyze an initiative to reduce reliance on ratings for capital adequacy assessment in the insurance industry and its effect on insurers’ investment and financing decisions. After the change, insurers are less likely to repair regulatory capital by selling distressed MBS, gains trading corporate bonds, or raising external capital. However, the new regime allows insurers to purchase more low-rated MBS. Thus, the initiative may limit systemic risk transmission through the asset liquidation channel, but at the expense of more risk-taking than prudential regulators may prefer.